Why We Still Like Emerging Markets

Our clients are concerned about where to invest during these volatile economic times. Should they seek the stable haven of fixed-income securities or should they go into the more volatile equity markets? And if they have the stomach for equities, should they flee from emerging market indexes that have seem to have lost their luster or should they stick with the US equity markets that have posted outstanding returns?

Here at Accretive Wealth, we believe the best long-term strategy for our clients is to remain with the domestic equity market but very gradually begin increasing their emerging markets allocation. We think emerging markets are somewhat undervalued at current levels and have more robust growth prospects in the long run.

Emerging markets may not seem like such a hot buy right now. Consider the MSCI EM, the premier emerging market index, which has posted losses of about 12% so far this year. When compared to the US’s major equity indexes (the S&P 500 and Dow Jones Industrial Average), which have posted year-to-date gains of 20% and 16.5%, respectively, it seems ludicrous to suggest that emerging markets would be a good choice. But the picture is more complicated than it may appear.

Take a long-term view

The financial industry, Wall Street in particular, has tended to take a short-term view of investments. Taking a longer-term view reveals that while the MSCI EM has returned 13% since 2000, the S&P 500 has returned only 7%. We expect this long-term trend to continue, and we think that investors shouldn’t pay so much attention to short-term performance.

Emerging market stocks are trading close to the bottom of their recent historical levels. Since the 1990s, emerging markets have traded in a range of 8 to 18 times their price/earnings (P/E) ratios. They are currently trading at a P/E ratio of around 10x, while developed market stocks are trading at around a P/E ratio of about 13x.

Another important factor to keep in mind is that developing economies are projected to grow about 5.2% this year, while developed economies are expected to grow just 1.3%. Emerging markets look a lot better now, don’t they?

US markets won’t stay this hot

We think the main reason investors have flocked to US securities and equities is because they don’t think they have a better option now. While investor confidence in the US markets fell to very low levels in the wake of the financial crisis of 2008, that confidence has rebounded. Certainly some of the gains in US equities are due to market correction, but keep in mind that the US equity markets have continued to post strong returns even when economic news is not very encouraging. We suspect that some investors are storing their funds in US markets for the time being but intend to get out in the near future. If that were to happen, US markets would take a big hit.

We certainly don’t mean to imply that emerging markets will post an immediate turnaround. They won’t, for many reasons, the biggest of which is instability. Citizens in developing countries are just beginning to come to terms with their newfound prosperity and are calling for social reform. Huge crowds in India and Brazil have recently protested corruption and governmental inefficiency. Many emerging market countries have just experienced or are heading into leadership changes and thus encountering temporary political instability. And Russia and Brazil will both be hosting major sporting events next year (2014 Winter Olympics and 2014 FIFA World Cup, respectively) yet are struggling to have facilities ready in time.

Even considering all of these problems, though, emerging markets are showing promising signs of growth. China’s markets have begun to rebound strongly after the initial shock of lower-than-expected growth, while Russia is witnessing a surge in demand for natural resources.

While we do not believe the present growth of the US equity markets is sustainable, we also don’t think the growth will falter significantly in the next year or so. In preparation for the expected rise in emerging markets, we recommend that our clients use the next 12 to 18 months to gradually increase their allocation to emerging markets to arrive at a more diversified portfolio.